Posted on 06/19/2006 12:17:01 PM PDT by devane617
Two class action lawsuits filed by hedge funds in Manhattan federal court indicate major problems in U.S. stock markets. The hedge funds blame big brokerage firms for failing to deliver shares of stock "sold short" by the hedge funds. The problem: buyers who paid for shares didn't get the stock, but don't know it.
The hedge funds - Electronic Trading Group LLC and Quark Fund LLC - say they were swindled by their "prime brokers," including Merrill Lynch, Banc of America Securities, Goldman Sachs, Lehman Brothers, Citigroup, Bear Stearns and Morgan Stanley. ETG and Quark allege their prime brokers conspired to charge very high fees for securities lending services and to fail-to- deliver (FTD) shares required by law for "short sale" purposes.
In separate suits, ETG and Quark allege the conspiracy also defrauded other hedge funds in the same way over a period of years. They ask the court to certify a class of all such hedge funds so all may recover damages.
The prime brokers may implicate the hedge funds in the FTDs. But filing of the suits is unlikely unless many shares sold remain undelivered.
If that is true, many buyers have paid for shares they never received from short-selling hedge funds. Some of these buyers have resold the shares to others, not knowing they had no shares to deliver. Hedge funds have billions in assets and are active traders. The number of "phantom" shares may be very large.
How this could occur in the heavily regulated U. S. securities markets is unclear. SEC regulations require shares to be delivered within three days after trade (T+3), when funds are paid (cleared) and shares delivered (settled). Most clearing and settling is done through Depository Trust & Clearing Corp. (DTCC), a private firm organized and controlled by the securities industry.
SEC regulations permit shares to be "sold short" only if the seller has access to borrow shares and does so after the sale, meeting the T+3 deadline. The hedge fund suits allege that DTCC clears funds to short sellers without actual delivery of shares, and that the prime brokers have exploited this flaw in procedures to create many FTDs.
Evidence shows T+3 often is not met. Regulations allow the seller to be "bought in" by the receiving brokers if delivery is not made within ten days after the trade. But the hedge fund plaintiffs say brokers seldom do this when large hedge fund clients are involved.
DTCC has been asked how many FTDs are occurring, but refuses to disclose FTD data, either for particular companies or for the general market, citing concerns for possible trading volatility.
Despite its professed fears of trading volatility if FTD data is known by the public, DTCC says FTDs are minor matters. But DTCC frequently uses discretion to transfer pending FTDs to private brokerages involved for resolution "ex-clearing" among them. The number of FTDs in ex-clearing is unknown to the public.
Issuers of shares affected by FTDs have complained to DTCC regarding its failure to enforce the "buy in" rule to cover FTDs ten days after the trade. DTCC states it has no authority to "buy in" brokers or their delinquent clients.
The SEC has received related complaints for years, but public enforcement actions have been minimal. The SEC adopted Regulation SHO effective Jan. 1, 2005, requiring brokerages to report FTDs in certain stock trades after that date. When the total FTDs in a stock reach a "threshold" level, the stock is named on a Reg SHO list.
The Reg SHO list names several hundred firms, most of them small, but provokes no public enforcement actions by the SEC. FTDs existing prior to 2005 were left unresolved by Reg SHO, and their present status is unknown.
Last year, SEC chairman William Donaldson was asked about FTDs, or "naked short selling," by Sen. Robert F. Bennett of Utah during Senate hearings. Donaldson asked to discuss the subject in closed session, which is out of character with information transparency sought in U.S. financial markets.
Christopher Cox became SEC chairman in 2005. In 2006, the agency provided FTD data to a NYSE-listed firm, Novastar Financial Inc. (NFI). The data covered daily trading in NFI shares during 2004 and 2005, revealing that on certain days as much as 40 percent of NFI shares traded were FTDs. On days with high FTDs, NFI's share price fell sharply.
Small investors call this fraudulent market manipulation and ask why the SEC does little to enforce "buy in" provisions of law. Some institutional investors report extended delays or no success at all in getting delivery of large lots bought.
In Utah, the governor recently signed into law a novel requirement that brokers report every FTD affecting the shares of any company organized or headquartered in the state. The Securities Industry Association lobbied hard against the measure that imposes liability of $10,000 for each day of violation.
On June 20, the U. S. Senate Judiciary Committee convenes a hearing on "short selling activities of hedge funds and independent analysts." No witness list is yet available, but may include the hedge funds and prime brokers named in the Manhattan class actions. The Committee may also invite (or subpoena) DTCC, SEC, NASD, NYSE and SIA.
This is an issue that is getting to big to handle and has lots of investors scared. According to a few sources that I read, as much as 40% of Institutional trades including Hedge Funds are goinf down as "Failed to Deliver"(FTD).
ping to investors
"Oh, you're a hedge!"
NO! Please...Never. am individual investor that is getting killed by these guys.
I was being silly--quoting Dudley Moore in "Arthur". Can't seem to be serious yet today.
It took me a while to figure out what NAKED SHORTS WERE.
So my understanding is as follows
long buying=paying cash for stocks
selling=selling stocks and getting cash
margin buying=borrowing cash to buy stock
short selling=borrowing stock to get cash
NAKED SHORT SELLING=SELLING STOCK THAT DOES NOT EXIST AND GETTING CASH
naked shorting is very close to counterfeiting/issueing your own currency.
basically, you print off currency that says "convertable to dollars" you give the currency to someone who accepts it, you get dollars to spend. Later, you get dollars from working and you pay the dollars back and get your "convertable to dollars" back.
naked shorting is where you "sell stock" get cash for it and deliver to the seller an entry in their brokerage account that says they own stock when they really own your promise that whenever they want to really own the stock, you will give it to them.
How exactly are "these guys" killing you?
I am asking a serious question - professional curiosity.
Feel free to be a technical or arcane as you wish -- you will still probabbly be clearer than the legal types in NY and DC I am forced to deal with several times a week...
You also did'nt take into account what options writers can do; all with the knowing participation of the brokerage houses. And don't forget the role that the DTCC and OCC play in the game, either.
Can't remember the details, but the book said "couldn't happen today because of the liquidity of markets". That was in
a book I read early 1980s.
I guess the economics have changed.
Hedge funds and large investors have been known to hire firms to bash stocks and put out news that is not always factual. Also, they have the ability to manipulate a stock in order to fill a short position.
Small investors in emerging companies, small to mid cap stocks, are along for the ride. Lately, or at least for the past couple of years you will see wild fluctuations in pps for no apparent reason, and a pattern will emerge that makes it appear to be manipulation. Naked Short selling is just one of many items that needs to be addressed in order to protect the interest of the company and small investor.
You're right, with the addition of one more clarifying snippet. Companies who issue shares have a precise number of shares that exist. Each and every one of those shares is owned by someone---either the co in the form of treasury stock, an investor large or small, or the market maker who is the middleman in essentially all extra-company stock transactions. (The co itself can grant shs to an officer, say, without the services of a market maker) Some of these naked shorts are promising to deliver shares that do not exist. So it's perfectly true that it is counterfeiting, not "like" counterfeiting, it's c-feit plain and simple. In some cases, the shares MIGHT be found somewhere given some time...but if they cannot be delivered it's a stark indictment of the shorting entity.
I think naked is just a derogatory term for ordinary short selling. When I short, I "borrow" shares from an stock owner who doesn't even know they are being borrowed. It's the same bookkeeping that you describe as being naked.
"stark indictment of the shorting entity."
So, you might say we've moved from naked shorts to stark naked shorts.
But its the brokerage firm, not the hedge fund, that is responsible for lending the shares to the short-seller to sell. If there are no shares to lend they have defrauded the hedge fund, unless there is collusion.
LoL. Been there, had that argument. 1) small time shorts like myself dump more money into the market then we take out. 2) shorting smooths market peaks and troughs. In short, it is a fully legitimate way to prevent overvaluation and undervaluation. OTOH, from bitter experience, it is also a good way to lose lots of money.
naked shorting is the same as regular shorting except in naked shorting you borrow the same stock more than once or you just dispense with the formality and borrow stock that simply does not exist.
I guess I was wrong. Then there is a difference and in naked shorting there would be no bookkeeping entry for borrowed shares. When I short, I presume my brokerage borrows real shares electronically from another account or another brokerage or somewhere.
As you are perfectly aware, but I'll state it for anyone contemplating shorting on a lark, the difference between long and short selling is in the limits of what you can lose.
You can lose no more than all of the money you invest long.
When going short, you are committed to buy back and the amount you must pay if the stock shoots the moon is theoretically unlimited. There is no limit to what you can lose going short.
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